Inflation below target over medium term, but upside risks

The BoE's forecast revisions in their August Inflation Report were broadly as expected, with the GDP growth outlook revised down but the near-term inflation outlook revised up. Over the medium-term though, the MPC's central expectation is for inflation to remain a little below target. However, with the risks skewed to the upside, they judge that the overall probability of undershooting the inflation target over the medium term is only slightly greater than 50%. That outlook, the large uncertainties around it, and some divergences in views within the MPC in recent months weigh towards both interest rates and QE remaining on hold for a considerable period, in our view.


Growth lower on weaker confidence, tight credit, fiscal tightening

As anticipated, the MPC revised down their central GDP growth forecasts over the next few quarters. However, with their central path for GDP still showing growth of around 3% per annum from mid-2011 onwards, they remain somewhat above consensus. That said, they continue to see the balance of risks as being heavily skewed to the downside.

The additional fiscal tightening announced in the emergency Budget, weaker confidence and a slower-than-expected improvement in credit conditions were cited as the main factors contributing to the weaker growth outlook. Both the Inflation Report and Mervyn King noted however that while fiscal tightening had lowered the central GDP growth outlook, it had reduced some of the downside risks around it from higher long-term interest rates, and might have also contributed to the rise in sterling by reducing the risk premium on UK assets.

As part of assessing their recent forecasting record, the Inflation Report noted that GDP growth in recent quarters had been in line with their expectations around a year ago. While the growth outlook had deteriorated in recent months, Mervyn King nevertheless took the view that it was too early to judge that the recovery was struggling. But of course he was well aware of the recent deterioration in some indicators.


Inflation outlook higher near-term, slightly lower medium term

Reflecting the additional rise in VAT announced in the emergency Budget, the MPC revised up their near-term inflation forecasts notably. With the BoE's regional agents reporting that the 2.5ppt VAT rise in January 2011 could be passed on by retailers to a greater extent than the 2.5ppt rise in January 2010, all else equal that could have a marked upward impact on inflation.

Nevertheless, the MPC continue to highlight that they focus on the medium-term inflation outlook. As those VAT effects drop out, the MPC continue to expect CPI inflation to fall back below target in early 2012 (to around 1.3%) before drifting slowly back up again - reaching around 1.7% by the end of their 3-year forecast horizon.

However, with the MPC taking the view that the risks to the inflation outlook are skewed to the upside, the overall probability of inflation lying below target over the medium term is judged to be only slightly above 50% (and is 50% by the end of the 3yr period). Moreover, the uncertainties around those forecasts are considerable: the MPC judge that there is around a 40% chance of CPI inflation being below 1.5% in mid-2013, but a circa 35% chance of inflation being above 2.5%. So there are sizeable risks in both directions.

Those risks have considerable weight in the MPC's decisions, and relatedly some members' medium-term inflation concerns have risen in recent months, while others' have waned. That could make a majority decision to change policy in either direction more difficult to attain. So with the outlook judged to remain highly uncertain and neither upside nor downside risks dominating sufficiently, the August Inflation Report may weigh towards the MPC remaining on hold over the next few months.